Whether the dispute relates to contract issues, patent infringement, franchisee-franchisor matters or other torts, there is often the need to reference lengthy agreements and voluminous documentation and perform detailed calculations. Expert accountants are usually retained by both the plaintiff and defendant to assist in estimating damages, and to help the court understand these calculations and conclusions.
While provincial and federal Rules of Civil Procedure set out guidelines that must be followed by expert witnesses, they do not specify the level of care and diligence that an expert must follow when preparing their report. It is up to the expert, in fulfilling his or her duty to the court, to ensure that the utmost care is taken when preparing their report, which should include meeting the requirements of their professional associations. In addition to meeting these minimum criteria, a prudent accounting expert will go beyond just the numbers, and delve deeper to understand and assess the impact of "business reality" in a damages calculation.
This article examines the standards that should be followed by an expert accountant, and why an expert accountant's damage report should involve more than just adding up the numbers.
What is an expert witness?
Expert witnesses are often called upon in litigation to provide clarity to the court on complex matters. They review information provided during the proceeding, and in combination with their own research and experience, provide an opinion on the matter at hand. In the case of expert accountants, this may include performing financial analyses and calculations of damages.
Over the past few years, there have been changes to the framework and rules related to the use and conduct of expert witnesses in Canada. For example, in January 2009, Nova Scotia introduced new rules regarding expert witness reports and related matters that require an expert witness to formally state in his or her report that the opinion provided is objective and for the assistance of the court.
On January 1, 2010, new requirements for expert witnesses came into force in Ontario through revisions to the province's Rules of Civil Procedure that codifies that an expert must provide fair, objective and non-partisan evidence that is within his or her area of expertise. British Columbia saw a similar rule change, effective July 1, 2010. In addition, the Federal Court implemented similar rule changes in 2010.1 Case law also provides that these same high standards are expected and required in all other Canadian jurisdictions.
Standards for expert accountants
Professional standards exist in Canada that are directly relevant to accountants and certain others who prepare expert reports to be used in disputes. These standards have been prepared by organizations that govern certain professionals who are regularly called upon to provide accounting expert reports to assist in dispute-related and other defined matters.
These standards have been prepared and published by two organizations:
- The Canadian Institute of Chartered Business Valuators (CICBV); and
- Alliance for Excellence in Investigative and Forensic Accounting (IFA Alliance).
These professional bodies issue standards to guide the conduct of engagements and the preparation of reports that fall within the scope of CICBV and/or IFA Alliance practices.
These standards are relevant to Canadian Chartered Accountants (CA)2 and/or Chartered Business Valuators (CBV). The relevant standards provide guidance and requirements for the review, analysis and reporting required in relevant expert reports. Even if an expert is not a CA or a CBV, the indicated standards can be viewed as providing a key reference source and guidance for those engaged in the preparation of financial, valuation and accounting related expert reports and analysis. At a minimum, these standards provide what can be considered to be leading practice for the preparation of such reports. Following these leading practices helps to ensure that expert reports that deal with accounting, financial and investigative matters have been prepared and presented in a manner that increases their transparency, reliability and understandability.
Interpreting the standards
The following provides an overview of concepts that form part of the relevant professional standards for the preparation of expert accounting reports:
- All relevant information should be identified, analyzed, assessed and compared to permit an informed consideration of substance over form, and to develop and test, as needed, hypotheses for the purpose of evaluating relevant issues;
- The reasonableness and consistency of all estimates and assumptions should be evaluated in light of the professional's expertise and other available relevant information. Where estimates and assumptions are provided that are outside of the professional's expertise, this should be made evident to the reader of the report and there should be consideration of the reasonableness of those estimates and assumptions before relying on them;
- Findings and conclusions should be presented in an objective and unbiased manner;
- Findings and conclusions should be confined to subject matter, principles and methodologies within the professional's knowledge, skill, experience, training and education;
- Prior to the issuance of a report, the professional should be satisfied that there is sufficient support for the content of the report, including any findings and conclusions reached. When a conclusion is qualified by a scope limitation, the limitation needs to be explained with reasons for the limitation and disclosure of the potential impact on conclusions. When the scope of review has been significantly restricted, or information provided is substantially incomplete, the ability to provide an unqualified conclusion should be assessed; and
- The report should provide sufficient information to allow a reader to understand how the stated conclusions were arrived at.
This means that a prudent accounting expert witness will go beyond a cursory review of the numbers to provide an appropriate analysis that reflects an understanding of the business reality of the situation. The examples that follow delve into common situations where it is necessary to investigate what is really behind the numbers:
- The identification and review of information;
- Evaluation of assumptions; and
- Determining the business reality of an organization's financial results.
Getting behind the numbers
Identification and review of information
Documents, facts, and evidence are the foundation of any litigated matter. The accuracy and reliability of this information should be closely examined and challenged. IFA Standard 400.05 specifically states that, "IFA practitioners should identify, analyze, assess and compare all relevant information, assess substance over form, and develop and test, as needed, hypotheses for the purpose of evaluating the issues in the IFA engagement." Questions should be asked such as: Who provided the information? Can it be independently verified? Is there a better source of information? Further, the completeness of the information should also be challenged, as the quest for information does not end with the plaintiff's documentation. Sometimes important data may not have been requested, may not have been obtained, or may have been overlooked by the plaintiff's accountant.
It may be necessary to seek out other relevant information, as follows:
- Statistics and other data about the industry, the company, and its position relevant to other competitors in the market. This information can provide information about the expected performance of the plaintiff company.
- Knowledge gained through interviews with competitors, customers, and suppliers. These enquiries can be helpful in gaining an understanding of how the issues in question affected the plaintiff's business. Approaches to external parties should only be made with the concurrence of legal counsel who will be considering various legal, strategic and other issues.
- Discovery transcripts of each party's representatives.
- Other relevant information from the plaintiff company. The nature of this information will depend on the theory of loss and the specific circumstances of the case.
Another consideration is how the information obtained was interpreted. Statistics or other data may be misconstrued, or the analysis may include data that has been incorrectly extracted from documents. The review of information relied upon and an understanding of how it was used can, by itself, lead to useful comments that can bring into question the estimated loss.
Evaluations of assumptions
Objective evidence is not always available in a damage calculation. In order to calculate a loss, assumptions are often required to compensate for information that is not available.
Certain assumptions may be stated explicitly in an expert accountant's report; however, there are often many assumptions that are implicit, or not highlighted within a report or loss calculation. The assumptions, both explicit and implicit, are often the weakest part of the accountant's estimate of damages and thus require a complete and thorough review. Minor changes in assumptions can at times have a profound impact on the quantum of losses calculated.
IFA Standards require an evaluation of all assumptions that are within the accountant's expertise; for assumptions outside of their expertise, the expert accountant should assess the reasonability of those assumptions.3 CICBV Standards require that the expert classify assumptions into (i) those that they are directed to take, that are not within his/her expertise; (ii) assumptions the expert has made and are within his/ her expertise; and (iii) assumptions that he/she was directed to take that are within his/her expertise, but the expert was not provided an opportunity to add assurance to the assumption.4
Questions that should be asked regarding the assumptions made may include:
- Why was each assumption made and was it necessary?
- Is the assumption reasonable?
- What information is available to support the assumption?
- Is there information that conflicts with the assumption, or brings the practicality or appropriateness of the assumption into question?
- Which assumptions are critical to the calculation?
- Are alternative assumptions possible and/or more probable?
- Do the assumptions, and resulting loss, make sound business sense?
- Has the accountant been provided with and accepted assumptions without question?
The answers to these questions will help determine whether and how to comment on various assumptions in the expert accountant's report.
Determining the business reality of an organization's financial results
In litigation, calculated losses must flow from the alleged wrongdoing. An expert accountant can help to distinguish the origin of certain losses, and what should be properly included and/or excluded from the loss calculation.
IFA Standard Practice 400.01 requires that, "IFA practitioners should use an investigative mindset5 in the identification, pursuit, analysis and evaluation of information relevant to each IFA engagement, contemplating that it may be biased, false, unreliable and/or incomplete." This investigative mindset should be applied throughout the entire engagement. The following section discusses a few examples where this increased need to "investigate" the numbers is especially pertinent when calculating damages:
"Personal" vs. "business expenses"– It is our experience with owner managed businesses that non-business expenses are commonly expensed in the records of the company. This may be done intentionally to reduce the tax liability, or it can happen in error. Regardless, personal expenses should not be included in the calculation of damages as they usually do not flow from the alleged action, and a careful examination of what is considered a "personal expense" versus a "business expense" must be performed. Areas that are particularly challenging to assess and require judgment may include:
- Gifts and entertainment
- Allocation of home office expenses
- Certain promotional activities
- Payroll and expense reimbursement for family members
- Car expenses
- Loan and interest payments
The appropriate classification can usually be easily verified upon the examination of supporting documentation.
Losses that are within the control of the business owner– The need to understand these types of losses is particularly common in assessing damages in disputes that involve alleged negligent misrepresentation of potential profits or business results, such as in a franchisee-franchisor dispute. For example, there are certain expenses that are prescribed by a franchise agreement: rent, royalties, advertising fees, etc. However, much of a franchisee's net profits are determined by how well they manage other expenses that are within their control, such as payroll, shrinkage, and other inventory losses.
Losses flowing from market or other external factors– Certain types of claims require assumptions to be made as to what would have happened in the "but for" world. For example, in a patent infringement case, a plaintiff may be able to elect to be compensated with damages. An assessment of the potential impact of various factors external to the business must be made, including:
- What was the impact on the business and the claimed loss of the general economy? A loss of income that would include, for example, the period after the market turmoil in 2008 would need to appropriately assess the impact on the business.
- Where was the business in its growth cycle? For example, a young company in a high growth phase may experience a higher rate of loss than a more mature company would.
- What would have been the impact of competitors in the market? The strength and nature of competition is very relevant to an assessment of damages and often requires consideration in damage estimates.
For each of these factors, and others, it is critical for an expert accountant to examine the evidence and provide analysis to support their estimates of loss. The expert must take both a micro and macro view of the business operations to truly assess the impact of these various factors.
When to involve an expert accountant
With any dispute, there will be many issues of a factual and technical nature that must be addressed with respect to establishing liability. Although these issues are fundamental to any dispute, it is, in our view and based upon our experience, important to recognize that questions related to damages are often best considered as early in a proceeding as possible. Much useful and necessary information to assist with reviewing damage issues can be best obtained as the action proceeds.
Involving the expert accountant at the start of an action will also give the accountant the opportunity to identify:
- The nature, extent and suitability of information available;
- Documentation that has not been relied upon by the expert retained by other parties to the action that should be requested;
- The degree of precision required in estimating the loss; and
- Any alternative approaches that require further investigation.6
The provincial rules of civil procedure will also have timelines related to the production of expert reports. These timelines may suggest that retaining the expert accountant can occur as the trial approaches. In our experience, such an approach often causes difficulties that will impact the quality and usefulness of an expert accountant's report.
Estimating damages is not just a matter of adding up the numbers. More often than not, this work requires a sufficiently deep investigation into what is behind those numbers. Not only is this leading practice, but it is also necessary to comply with certain professional standards. Regardless of the professional requirements, a strong expert accountant will go beyond the numbers to truly understand the business reality of a situation to provide a robust and supportable calculation of damages.
1 Canada Gazette, http://gazette.gc.ca/rp-pr/p2/2010/2010-08-18/html/sor-dors176-eng.html
2 The IFA Alliance was established by the Canadian Institute of Chartered Accountants and it is stated in the IFA Alliance "Standard Practices for Investigative and Forensic Accounting Engagements" dated November 2006 that: "All Chartered Accountants performing IFA engagements commencing on or after March 1, 2007 will be required to follow these Standard Practices." Also, chartered accountants practising in Ontario who are members of the Institute of Chartered Accountants of Ontario (ICAO) must comply with Rule 203.1 of the ICAO Rules of Professional Conduct which states: "A member shall sustain professional competence by keeping informed of, and complying with, developments in professional standards in all functions in which the member practises or is relied upon because of the member's calling." Canadian chartered accountants who are members of institutes of other provinces are governed by the rules of those institutes.
3 IFA Standards 400.10 and 400.11.
4 CICBV Standard No. 310, 9.2E.
5 "An "investigative mindset" requires a skeptical attitude in the identification, pursuit, analysis and evaluation of information relevant to each engagement, contemplating that it may be biased, false and/or incomplete. This is applicable in identifying and assessing relevant issues, assessing the plausibility of the underlying assumptions, assessing substance over form, and developing hypotheses for the purpose of addressing the issues under investigation." IFA Standard 100.11.
6 Zier, Joe. The Expert Accountant in Civil Litigation, Butterworths Canada Ltd. (1993).
* Article first published in the Corporate Litigation Journal by Federated Press, Volume XII, No.3, 2011
Becky Seidler is a Vice President of KPMG Forensic. She is a Chartered Accountant, a Chartered Business Valuator and holds an Honours Bachelor of Business Administration degree. Becky has assisted clients in estimating damages in a variety of claims. With eight years of public accounting experience, she has also assisted clients in litigation support, loss quantification, investigation, anti-bribery and corruption, contract compliance, data analytic, and internal control assignments.
Contact: firstname.lastname@example.org or (416) 777-3439